The term “mental accounting” describes a specific type of irrational investor behavior. It’s an irrational attitude investors can take when separating their money for investment. But I think a little “mental accounting” can actually be beneficial for families that are investing for generations. Let me tell you why.
Money mind games
How is mental accounting irrational? Let’s assume an investor saved $100,000 from years of hard work, then got $50,000 as a surprise bonus from their job, and then won another $50,000 in the lottery. This person might separate these amounts into three mental “pots.” They might:
- Leave the $100,000 in cash to be safe (they worked hard for this money)
- Invest the bonus from work in some stock mutual funds (they don’t mind losing a little because it was from a “bonus”)
- Take the $50,000 from the lottery and put it into a speculative penny stock. After all, this was found money, so they don’t mind if they lose it.
You can probably see why many would consider the behavior irrational. The investor would be horrified if they lost a dime of the money they saved from hard work, but they are willing to take all of the money from the lottery and gamble it on a penny stock. A dollar of loss affects the investor’s net worth the same either way, but the emotional impact is very different due to mental accounting.
However, when I help families saving and investing for generations, sometimes I encourage a little mental accounting. Sometimes it is the only thing that preserves family wealth. For example, most of the inheritance my father received was from a stock that my great-grandfather ordered his son to never sell! Luckily, the son, my grandfather, never did.
That is positive mental accounting, mentally setting aside one asset that is sacrosanct, and absolutely cannot be sold. In my family’s wealth history, this stock was also the primary part of my great-grandfather’s wealth that wasn’t frittered away one way or another. Often the only money that makes it through generations is the money specifically separated from the wealth that ends up getting used for everything else. Accounting-wise, it may just be an irrational “mental” bucket, but as the decades go by, the money that remains is usually the money that was specifically cordoned off.